What is the relationship between inflation and interest rate? What are they, when do they vary and why are they indicative of the health of a country’s economy? Here are the answers to these questions.
Inflation and interest rate are closely connected elements and are two important indicators of a country’s economy.
To better understand the relationship between these two key economic factors, it is important to analyze them in detail and understand them thoroughly.
What is inflation?
Inflation is the generalized and prolonged increase in the price level of a nation’s goods and services. To monitor the trend, a basket of products aimed at measuring the consumption of citizens is taken as a reference.
This rise in the price level leads to a weakening of the currency, since it has lower purchasing power.
Inflation implies, as a first consequence, that consumers tend to buy fewer products, as their purchasing power falls.
This phenomenon has several causes, one of which may be the excessive production of money, but mainly it all depends on demand. In moments in which demand is lower than supply, the inflation mechanism takes place, given that the good in question is produced at excessive levels.
Why does inflation change?
Depending on the economic situation, inflation can vary: if a country has a strong, stable economy and therefore tends to grow, the level of inflation tends to rise because in a strong economy many people have great liquidity and can spend more easily.
The currency therefore circulates in greater quantity and therefore tends to "inflate" with its consequent depreciation and increase in prices.
Otherwise, or in a difficult economic situation, the reverse happens. In fact, in a economy in crisis, far fewer people have liquidity, so the currency circulates in smaller quantities, inflation inevitably falls and there is a risk of recession.
The level of inflation must be kept under control to ensure the right balance between supply and demand, inflation must not be too high or too low, this task is up to the central bank of a country (here the ECB, in the U.S.A. Fed and so on).
All central banks, to keep inflation under control, act in the same way: manipulating the interest rate of the currency.
Inflation and interest rates: an indissoluble link
The interest rate represents the return on the currency, for the owner, but also the cost of the same for the borrower, ie how much he has to pay to repay it.
In a strong economic scenario when inflation rises, the central bank of a country raises interest rates, that is, it increases the cost of money to discourage access to credit; in this way less currency begins to circulate and, inevitably, inflation tends to decrease.
In a weak economic scenario, however, the opposite occurs. To stimulate the economy, and therefore the circulation of currency and consequently the increase in inflation, the central bank of a country lowers the interest rate to stimulate access to credit.
It is therefore the interest rate of the currency that defines, better than any other parameter, the health of a country’s economy.
